试听180秒032：How Does a Central Bank Operate Monetary Policy?

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Hello, Himalayas subscribers. My name is Timothy Taylor. 
Today we're going to discuss how does the central bank operate monetary policy. Mario Draghi has been the leader of the European central bank since 2011. Let me tell you his favorite joke about central bankers. Here's a man who needs a heart transplant. He goes to the doctor. The doctor says, I could give you the heart of a five-year-old boy. And the man says too young, not sure that would work for me. The doctor says, how about the heart of a forty-year-old investment banker? And the man says they don't have a heart. The doctor says, what about the heart of a seventy-five-year-old central banker? The man says, I’ll take it, and the doctor says, but why? He's seventy-five years old. And the man says, well, a central banker has a heart. It's just never been used. 

In this lecture, we want about talk about the tools that the People’s Bank of China uses to conduct monetary policy. And as we'll see, for the People's Bank of China and for all central banks, it's not really about heart, it's about understanding the economy and understanding the tools you have to affect. We'll talk about three tools in particular. First, reserve requirements, second open market operations and third direct liquidity for banks. 

First, let's talk about reserve requirements. And what is a reserve requirement exactly? Well, a reserve requirement is the percentage of bank deposits that the bank is not allowed to lend out. Instead, the bank needs to keep this amount on reserve. It needs to deposit that amount in an account hold by the central bank. 

Every bank is required to keep some of its deposits on reserve. If the reserve requirement goes up, then banks have to put more money at the central bank. They would have less money to lend out, and interest rates will tend to rise. If the reserve requirement is reduced, then banks will tend to have more money to lend out. And with more supply of money to be loaned out, the interest rate will tend to fall. Changing the reserve requirement has been in the last couple of decades, probably the most common monetary policy tool used by the People’s Bank of China, for example, the reserve rate was gradually lifted up in many small steps from 8.5 percent of bank deposits in 2006 to about 21 percent of bank deposits by 2011. 

That higher reserve requirement tells you the central bank was acting to restrain the supply of bank credit and lending in the economy, so it wouldn't grow quite as fast. Why do such a thing? Why restrain the growth of lending and credit? Or remember that over time, you want aggregate of the demand and aggregate of supply to be growing at about the same pace. You don't want one to be exceeding the other. Since about 2011, the reserve requirement has been coming back down. The reserve requirement in 2018 was reduced, uh, in April to 16 percent for larger banks and 14 percent for smaller banks. 

That lower reserve requirement meant the central bank was acting to encourage a greater supply of bank credit and lending in the economy. Let's mention a few other questions that often come up when talking about reserve requirements and the People's Bank of China. When banks are required to put reserves with the People's Bank of China, does the bank get paid interest? The answer is yes, but not a whole lot. The interest rate on bank reserves paid by the People’s Bank of China to the banks was about 1.6 percent early in 2018, while a common rate that banks can get on commercial loans is more like 5 percent. So, banks in China typically trying to hold, not to hold anymore in reserves than they are actually required to do. 

Another issue is what about lending? That doesn't happen through banks. Reserve requirements affect banks and bank lending. But there are other kinds of lending that happen from financial firms and investors who are not banks. Thus, if you make the reserve requirement higher, that can mean banks lend less. However, perhaps other lending in the economy could increase to some extent. So, thinking about that factor of other lending and nonbank lending is something we'll have to come back to. 

Most central banks all over the world have reserve requirements. It’s a basic tool of central banking, but in most other countries, the reserve requirement has not been the most commonly used tool of monetary policy. And since about 2015, this People's Bank of China has been shifting away from using the reserve requirement all the time as its main tool of monetary policy. And shifting to the next tool will talk about, and that is open market operations. An open market operation refers to a situation where the central bank buys or sells bonds with the goal of decreasing or increasing the supply of lending and credit in an economy. 

Now let's walk through how this works. First, remember what a bond is. We talked about this back in the financial investment lecture. A bond is a way for big organizations to borrow large amounts of money. It could be a company. It could be a branch of government that issues the bond. Uh, sometimes you might hear a reference to T-bills. A T-bills is a reference to bonds issued by the US government through its, the US Department of Treasury. When any big organization issues bonds, it agrees to pay a certain rate of interest over a period of time, and then to repay what it is borrowed. At the end of that time period, when banks get deposits from customers, the banks always have a choice. They can either look for a borrower and lend to that borrower directly, or the bank can buy bonds, and then it receives interest paid by whoever issued those bonds. Now, let's think about the situation between banks and the People's Bank of China. If the bank buys bonds, then it is not using that money to lend out. 

So now the People's Bank of China comes along with an open market operation, and it announces its going to buy bonds from banks. In that situation, the central bank, the People's Bank of China, gets the bonds, and the bank gets money. Now, the bank has more money to lend. Conversely, if the People's Bank of China sells bonds to banks, then the banks are holding bonds, but they gave money to the People's Bank of China. So, the banks now have less money to lend out. What central banks around the world like about open market operations is you can specify exactly how many bonds will be bought or sold, and you can see the result happening out there in the economy. 

But in using open market operations, the People's Bank of China is making another shift. Instead of focusing on the quantities bought and sold, or the quantity of a reserve requirement, it is starting to focus monetary policy on raising and lowering interest rates for the economy as a whole. Up until about 2015, the interest rates that banks in China paid to depositors or that Chinese banks charge to borrowers were under tight government control. But since then, banks are now allowed to compete against each other to decide what they will pay to depositors and what interest rate they will charge to lenders. 

These open market operations will affect interest rates. To understand why, remember the idea we talked about earlier when talking about financial investments, there is a tradeoff between risk and return when something is very safe, the rate of return tends to be low. It’s risky, then often you need to pay more to make up for the risk. And this is true of interest rates. If you're a very safe borrower, you're very likely to repay. Like when a government agency borrows, it tends to have a very low interest rate. But if a young and risky company wants to borrow, well, that young and risky company will need to pay a higher interest rate to make up for the risk that's involved. 

Now when you think about the economy, you can imagine all different kinds of risk for different kinds of borrowers at different levels of government, different sizes and kinds of companies in different industries are different individuals with different levels of income borrowing for different purposes. So you'll see many, many different interest rates all around the economy, reflecting all these different risks. 

Now, with all this in mind, let's think about one of the very, very safest loans that exists in any economy. And that's the interest rate that happens when one bank borrows from another bank for a very short-term loan, like just a few days. So, the idea of the central bank is its going to use open market operations to focus on this very specific safe interest rate. If the central bank makes this one specific safe interest rate go up, the idea is all the other interest rates in the economy, which are riskier, will also need to rise together with that safe interest rate. If it makes this one specific safe interest rate go down, all the other riskier rates will also need to decline all together. Now, in financial markets, this specific short-term interest rate, referring to short-term loans that banks make to other banks, that it has specific names. In the United States, for example, the US federal reserve focuses on a specific short-term interest rate called the federal funds rate. 

The People's Bank of China has been focusing on a short-term very low risk rate called the seven-day reverse repurchase rate. Now, these lectures are for beginners I won't even try to explain what a reverse repurchase agreement is, but just remember that it refers to very safe, very short-term loans that banks make to other banks. Now, as you would expect, raising and lowering interest rates doesn't work perfectly in this way. Interest rates are not like soldiers marching in a line, but it is generally true that if the central bank buys bonds from banks, then the banks have more money to lend, and that greater supply of lending causes all interest rates to fall across the economy. And if a central bank sells bonds to banks, then banks will have bonds instead of money, they'll have less money to lend, and the drop in supply of lending will cause interest rates to rise.

 There's one more main tool for monetary policy in China, and that is our third issue, uh, direct lending and liquidity for banks. Instead of focusing on affecting interest rates for the overall economy, the central bank can lend money directly to banks if it wishes to do so. The idea is these banks can borrow from the central bank and then lend to customers. And the People's Bank of China has created several main tools for doing this in recent years. 

For example, there's something called the standing lending facility, which makes loans mainly to small and medium sized financial institutions. There's the medium-term lending facility, which mostly makes loans aimed at bigger banks. And there's something called the pledged supplementary lending, which offers lower cost loans to specific banks, sometimes focused on specific industries. But the basic idea of all of this is clear. If banks can borrow lots of money cheaply from the People's Bank of China at a low interest rate, then it can also lend out that money. If the People’s Bank of China says it isn't going to make as many loans in this way, or it's going to charge higher interest rates, then that will restrict how much banks will be making loans based on that as well. 

Now I should add these different monetary policy tools sometimes work together. For example, earlier in 2018, the People's Bank of China reduced the reserve requirement, but then they required that banks take the extra money they now had available and use it to pay off loans they had received from the medium-term lending facility. 

There are other monetary policy tools used by other central banks around the world that are in different economic situations. There are also different ways of carrying out monetary policy, like whether you announced your plans in advance, whether you project out into the future what you're going to do, and how a central bank explains what its plans are going to be if conditions change. 

But at a basic level, the idea of monetary policy is fairly straightforward. It's using the interaction between the central bank and the banking system in a way that affects what quantity of loans banks are willing to make, in what interest rates are going to be charged in the economy. 

You sometimes hear a news reporter hear someone say that the central bank, somewhere in the world raised or lowered interest rates. Maybe it's the US federal reserve or the European central bank, or the People's Bank of China. When you hear that, you should now understand that's not precisely true. What's really happening is the central bank changed the reserve requirement or did open market operations or provided liquidity to banks or took some other step that had the effect of causing interest rates to rise or fall in the economy. That's what's happening behind the scenes. 

In the next lecture, we'll discuss whether a central bank that's carrying out monetary policy should try to follow a route set of rules that are set in advance, or whether it should decide each situation as it comes along. 

I'm Timothy Taylor. Thank you for listening to Himalaya.